A Different Perspective on Sequence-of-Returns Risk Around Retirement

Executive Summary

Investors saving for retirement must consider a range of factors, including the objectives they wish to achieve and the risks they are willing to take. One factor that often receives significant attention is sequence‑of‑returns (SoR) risk—the concern that portfolio losses around retirement could impact the ability to support postretirement income needs.

We recognize that investors may have different retirement objectives, resulting in different risk priorities. While some investors may rationally prefer a strategy that limits the variability of account balances around retirement, most are focused on achieving adequate, sustainable income streams during retirement.1

In target date investing, it is critical to align glide‑path design with investors’ objectives. To understand the potential trade‑offs, it is not only important to evaluate the magnitude of potential losses, but also to view that potential in the context of the full investment life cycle.

For investors with a longer‑term focus on longevity risk, the benefits of maintaining a growth‑oriented glide path in their accumulation phase could meaningfully outweigh the potential negative impact of a large market decline close to or soon after retirement.

Historically, equities have tended to generate higher intermediate‑ and long‑term returns compared with fixed income and cash assets. In our view, the benefits of capturing this equity risk premium outweigh the potential impact of SoR risk. Our analysis suggests that most investors could have achieved higher asset balances at and into retirement by following higher‑equity glide paths, even after experiencing large market declines close to retirement.

Evaluating the Impact of SoR Risk

To examine the trade‑offs required to manage SoR risk, we can measure possible outcomes using different glide paths. Our analysis here uses the benchmark glide paths represented in the S&P Target Date Indexes. This family of indexes is designed to reflect average asset allocations in the universe of glide paths currently available for different target dates, based on a survey of target date providers active in the market. For each available target date, S&P also maintains two sub‑style indexes―the S&P Target Date To Indexes and the S&P Target Date Through Indexes.

To understand the potential trade‑offs, it is not only important to evaluate the potential magnitude of losses, but also to view that potential in the context of the full investment life cycle and the financial outcomes investors are seeking. This approach allows us to identify the point at which a rational investor might be indifferent between the outcomes of two different glide paths. In other words, given the potential performances of the S&P indexes in the accumulation phase, how big of an equity bear market would it take to equalize the values of two portfolios tracking those same indexes?

A Strategically Higher Equity Glide Path Could Have Led to Better Outcomes Over the Last 10 Years

From this starting point, we can calculate the equity loss required to make the outcomes equal for both portfolios as they stood on December 31, 2017. In this analysis, we focus on portfolio balances because as a simplifying assumption the current balance can be viewed as the present value of future retirement spending. If we assume that an individual has a set spending strategy, then, all else being equal, a higher

balance potentially means that he or she could spend the same amount over a longer period (i.e., the stream of income would last longer) or spend more over a shorter horizon.

In both cases, the SoR risk resulting from market volatility near retirement could have a significant impact on retirement income. However, unless the equity decline were even larger than in the hypothetical scenarios outlined above, the more conservative “To” investor would not enjoy a withdrawal advantage over the more growth‑oriented “Through” investor. From an outcome‑oriented

perspective, the benefit of capturing the equity risk premium over a long investment horizon potentially would outweigh the impact of SoR risk.

Hypothetical Bear Market Outcomes in a Flat Fixed Income Market

As investors approach retirement, it is not surprising that they may become more sensitive to the risk of a short‑term market decline. However, a narrow focus on risk of loss does not take into account the full range of risks that retirement investors face. We believe it important to evaluate SoR risk in a broader, more holistic context, especially if we consider longevity risk and the fact that investors will likely need their income streams to last decades into retirement.

For investors who have had the opportunity to accumulate savings over the course of long working careers, higher-equity glide paths historically could have delivered higher retirement balances in the vast majority of long‑run periods, even after taking SoR risk into account. We believe investors would be wise to consider this experience when choosing target date strategies.

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of November 2018 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

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Jerome Clark is a portfolio manager in the T. Rowe Price Multi-Asset Division and co-manages the firm's Asset Allocation Target Date Strategies and oversees the College Savings Plan portfolios. He is a member of the firm's Asset Allocation Committee and a vice president of T. Rowe Price Group, Inc.

Kim DeDominicis is a vice president of T. Rowe Price Group, Inc., and T. Rowe Price Associates, Inc., and is an associate portfolio manager for all target date strategies. Mrs. DeDominicis is a vice president and Investment Advisory Committee member of the Balanced, Spectrum, Personal Strategy, and Retirement Funds. In addition, she serves as the chair of the T. Rowe Price College Savings Advisory Committee.

Wyatt A. Lee is a co-portfolio manager of the Retirement Date Strategies in the Multi-Asset Division. Mr. Lee also has portfolio management responsibilities for the Global Real Assets Equity Strategy. In addition, he serves on the Multi-Asset Steering Committee. He is a vice president of T. Rowe Price Group, Inc., and T. Rowe Price Associates, Inc.

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